EM Currency Devaluation Sparks Greater Interest in Hedging, Options

The risk manager at a transportation company said emerging market (EM) risk makes up a very small percent of its overall currency exposure. “It’s all relative,” she added. “While the decline in India and Brazil had a marginal impact on results, it wasn’t material” However, the impact on earnings in Q1 this year means that more companies have begun to reassess their hedging strategies in EMs.

“In the past year, many EM currencies went through significant volatility and a broad depreciation against the US dollar [USD],” said Amol Dhargalkar, managing director at hedge and derivatives accounting consulting group Chatham Financial. “We’ve definitely seen a lot of interest and conversation around emerging markets. While that’s been going on for a while, the interest has reached a crescendo this year.” According to Dhargalkar, companies have begun to look beyond balance sheet hedging into cash flow and net investment hedges.

India, Brazil and Russia stand out as the major headaches, according to Krishnan Iyengar vice president at Reval. For many companies that has meant Q1 earnings hits. The primary reason for these has been the re-measurement of non-functional currency balance sheets, or the valuing of foreign currency assets and liability at current spot rates for the profit and loss (P&L). While these currencies have rebounded since, they’re still relatively low. So Iyengar won’t be surprised if they become an issue on Q2 and Q3 earnings reports as well. “A lot of companies have not historically put in a balance sheet hedging programme in those markets,” he added.

Unfortunately, as was the case with the euro breakup scenario in 2012, it’s when that headline risk hits that many people stop to rethink their hedging strategy. “That’s when we see a big push to hedge the currency,” Iyengar said, although that’s exactly the wrong time to hedge because costs are exorbitant. “Often, it’s once board members see headline risk that they start to ask the tough questions.”

“People have stayed away from hedging in EM currencies in any prolific way because of cost,” said Ramon Bauza, managing director and head of FX risk advisory at Deutsche Bank. Then came the big devaluations of September 2013 and early this year. “In the last six to nine months, there’s been a sea change in corporate attitudes, as treasurers take a re-look at FX hedging policies and try to get a better handle on the cost of hedging, what products to use and which currency pairs,” he said. “Companies are getting more serious about hedging EM risks, despite the cost.”

“Within both the corporate and insurance space, we clearly see a reassessment and re-pricing of EM assets both in regards to risk and shareholder returns,” reports Erik Johnson, director in Citi’s unit CitiFX Client Solutions in London. That is not to indicate that medium and long term objectives have changed. There’s still a lot of positive sentiment about EM investments. However, “there’s a much broader understanding of EM risks.”

“Companies are thinking more strategically in terms of business development, not just hedging on the back end,” said Steve Jonathan, FX market specialist at Bloomberg. The dilemma many companies face is that on the one hand they did not go into the early-2014 crisis with enough hedges. On the other hand the cost of hedging is expensive relative to, for example, a euro hedge. But the sharp devaluation in currencies like the Indian rupee (INR) and Brazil real (BRL) “disabused them of that notion,” Jonathan said. “The next hedging decisions will be more informed about the risk and the alternatives. I’d like to think that’s driving people to be more aggressive and consider their business strategy combined with hedging strategy.”

Treasurers are also looking at EM currencies on a more granular basis. Jonathan cautions companies not to review them as a monolithic group. “Costa Rica and Brazil are both EM currencies but are so different in terms of products, markets and information transparency,” he said.

It’s also important to look beyond the exchange rate. “The impact of your exposure in a particular currency depends not just on the size of the exposure but another set of complicated factors, such as the currency volatility, correlation with other currencies and macro-economic factors,” said Dhargalkar.

At the same time, one of absolute trends emerging over 2014 is that group treasurers are really looking at the entire risk portfolio on a holistic basis, in an effort to understand the interplay between cost of hedging and risk reduction, according to Johnson. “Companies are looking to managing risk in a platform that makes it easier to understand measure and communicate to internal and external audiences,” he said.

They’re also looking for a methodology that’s linked to their objectives. Citi has developed several models that allow companies to assess and develop a rule-based approach to hedging EM currencies as well as developed market currencies. In EM currencies, the bank offers an early warning index that can help companies create rule-based approaches, as currency ‘red flags’ trigger changes in the ratio and duration of the hedge.

Case study

At one multibillion dollar project-based multinational, emerging markets account for 10-15% of overall exposure. “We’re exposed to India, China, Thailand, Chile, Peru and Brazil,” said the company’s risk management director. The type of exposure (long vs. short) varies by country. In China, India and Taiwan, the company hedges expenses for local offices, or is short the foreign currency. In the other markets, it has projects that generate local currency revenue, or is long the local currency.

The company uses a mix of operational and forward hedges to protect is project margins. In EMs where it’s long the currency, it builds the risk into its project by arranging contracts on a reimbursable basis, essentially transferring the risk to the local customer. In countries where it is short the currency, it hedges its cash flow risk using forwards, often for the duration of the project, which is typically two to three years. “We use deliverables forwards where they’re available,” the risk management director said. In China, the company hedges using the offshore renminbi (CNH) market in Hong Kong. The risk management strategy is similar across developed and emerging markets.

“We have a threshold amount. If the exposure exceeds that dollar figure we hedge 100% of known exposures,” he said. The duration of the hedge is the life of the project; however the tenor of the forwards depends on specific market liquidity issues. “We’re generally buying the currency, which means the forwards points are going in our favour.” The cost of hedging is also built into the analysis of each project’s profitability. “We shouldn’t be able to enter into a project unless we’ve already accounted for what it takes to get the money out of the market.”

Reducing the Cost of Hedging

Whether it’s India, Brazil or Indonesia, the challenge with many EM currencies is that the forward curve has ‘contango’ in it, meaning the spot rate is lower than the forward rate as a result of the differential in interest rates. This means that companies that are long the local currency have to pay out substantial forward points to hedge this exposure, a negative carry some do not wish to incur. “For companies with local currency revenue, hedging can be very expensive,” said Gupta. “Those companies need to think hard about the objective of their hedging strategy.”

While more companies hedge their balance sheet exposure, to eliminate the ‘noise’ from foreign currency gains or losses in income (the result of re-measuring local currency-denominated monetary assets and liabilities), it’s less common with cash flow hedges (hedges of anticipated exposures). In the case of balance sheet hedges, many companies, which hedge on a monthly or quarterly basis, have reduced the tenor of their forward hedges, reflecting the view that they expect the negative carry to become less so over time. “They’re locking in the negative carry for a shorter period of time,” Gupta said. Clients reduce tenor, reflecting a view that the carry is too high and may move in their favour over time.”

One possible way to reduce the impact of the negative carry is to use an at-the-money-forward (ATMF) purchased USD call to hedge the exposure. “Our back-testing shows that those can perform better over time,” Gupta said. The idea is to use options when the premium is comparable to the forward points, which can occur in medium-term hedges of EM currencies. That way, if the currency strengthens against the USD, the option will expire out of the money whereas the forward will result in hedge losses on both the currency’s appreciation and the forward points. If the currency depreciates against the dollar, both hedges will perform similarly: the company would be out the forward points while the option will expire in the money.

Deutsche Bank’s Bauza recommends a similar approach. “Over long periods of time, rolling collars offer a much better return than rolling forwards,” he said. “That’s because the forwards typically exaggerate where that currency pair is going to trade.” His analysis shows that a rolling collar strategy in Brazil and India has proved much cheaper than forwards. Conservative corporate hedgers, that typically use forwards, are moving to collar-based strategies to deal with the high cost of carry.”

EM currencies more volatile than majors but according to JP Morgan’s global currency index, overall FX market volatilities peaked in 2008 and have been steadily declining since. As volatilities declined, “the cost of hedging with options has been declining along with them,” said Scott Bilter, Partner at FX advisory firm Atlas Risk Advisory LLC. “Pricing in terms of volatilities has improved. This creates a better opportunity to hedge exposures that are suitable for options and potentially hedge further out.”


The events of early 2014 have caused some companies that have not previously hedged, or hedge only a small portion of the risk, to rethink their approach. However that has not led to a flood of hedging action. “They may go back and provide the same answers,” said Iyengar. “Some companies started to look that protect those exposure.” One trend he has noticed is that companies review the risk in a more holistic way, including multiple currencies and related commodity exposures, rather than in silos. “They look at their risk profile across asset classes.” When hedging is deemed too expensive, companies look to operational approaches to mitigating risk, such as currency of billing.

The Rupee

India is among the more interesting markets, particularly after last month’s elections. The new prime minister, Narendra Modi won in a landslide with margins not seen in decades, bringing new optimism to India’s economic outlook. That will help stabilize the rupee. “For India, the biggest challenge is inflation,” said Nitin Gupta, director, corporate foreign exchange at RBS. “We’re positive about the rupee’s prospects,” he said. The currency has fallen from a high of 68.85 in August 2013, to a low of 52.90 last February, rebounding to 59.20 this month but still a long way off its high (see chart below).

Tracking the Indian Rupee

Tracking the Indian Rupee

Source: Bloomberg

Some of the continued difficulty for India has to do with its lack of infrastructure, which has dented foreign direct investment. “There’s a lack of basic things (like reliable power and roads), which the economy needs to operate with less friction,” Gupta said. Some of this results from political factors and some of it has to do with red tape. The hope is that with the new government, there will be a more streamlined approval process that will encourage the flow of capital necessary to build that infrastructure. “Of course Modi is new. The market will have to see results,” Gupta added.


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